My partner and I are in the process of creating a long/short market neutral stock strategy for a hedge fund. He has done some very original research, and what he has created seems to work well as a stock selection filter for medium term (4-15 week) time periods.

Weâ€™re running into a few problems with creating the basic stop regime to be used with this strategy.

Market Neutral stock strategies are typically Beta, Sector, and dollar neutral, and ours is heading in this direction. Right now, we are in the initial exploration phase of research, and so the portfolios weâ€™ve created are roughly beta neutral (pretty close) and dollar neutral. We plan on testing sector neutrality soon. I expect it will show good results.

We donâ€™t really have a good exit strategy. Yes, I know â€“ its all about the exits, and thatâ€™s why Iâ€™ve decided to ask for some help.

We currently are looking at several ideas for initial, risk control exits

1. A typical turtle style, where we use a volatility measure to extract an expected price movement. If the stock moves against us by this amount, we exit the individual stock. This is a simple method, but leaves the portfolio unbalanced. We then balance the port using ETFs or futures.

You can see the massive problem with this in a market neutral portfolio context. If the market has a large move in one direction, all of the stocks will get stopped out for a loss. We are attempting to profit from the relative movement of the individual stocks in the portfolio, so getting stopped out really takes away Â½ of the potential return. That suggests not having a stop at all and just letting the portfolio go. However, as a futures trader, I canâ€™t stand the thought of being without some protective stop!! Itâ€™s really bothering me, so I came up withâ€¦

2. Create an â€˜indexâ€™ out of the stocks in the portfolio. Base the stops in relation to the movement of the index. For example if the index is going down overall, and one of the long stocks in the portfolio is going down much more relative to the index, we exit this stock, and replace with blah, blahâ€¦

This is a little better, as it fits better into the objective of the system â€“ to capture the relative price movement of stocks. Stocks that are not performing relatively well will be eliminated. To actually implement this regime, we could just calculate the volatility of the index. The index will move some â€˜xâ€™ volatility units in a day in one direction â€“ adjust all individual stock stops by â€˜xâ€™ volatility units in the same direction. So each individual stocks stop will move a different price amount, but will move the same amount in volatility.

This approach has several problems. One, the individual stocks that make up the index are in the portfolio too. As a result, their movements will impact the index. A move in several of the stocks will greatly impact the index, and so there might be an occasion where the stops just keep moving, and weâ€™re losing tons of money. Itâ€™s unlikely on any individual run, but we all know that unlikely and impossible are very different. Over a 10 year run, we can expect it to happen. The alternative of creating an index where the individual stock is excluded is massively complex, and would extremely difficult to execute without errors.

Another problem is how to measure risk for this method. As the overall movement is aggregated, the risk would have to be aggregated as well. This leaves us in a situation where were are risking a high percentage of equity on what is essentially one giant trade. If we are trading several sectors, it could turn out where we lose like 50% of equity in a matter of weeks after several good years of performance â€“ a typical short option strategy style payoff.

Using an outside index, for example an ETF for a sector solves some problems, but also introduces others. What is the correlation (and all of the problems with that measure) of the portfolio with the ETF? It could be less than ideal â€“ like in the 70% range. In other words just good enough to semi-trust, just bad enough to get burned.

So â€“ does anyone have experience, ideas or comments on this problem? Is there books, articles or anything on this? Also, note that I didnâ€™t even get into trailing stops. I need help â€“ and know it.

I would think there are several common approaches to this problem, I am just not familiar with those approaches.

If a trade contains just two instruments (like a long/short pairs trade), you go long S1 shares of instrument 1 at price P1, and you go short S2 shares of instrument 2 at price P2. Presumably you have got some kind of math formula that tells you how many shares to trade on a new entry signal, per million dollars of equity. Thus the numbers S1 and S2 are proportional to equity.

One thing you could certainly test is: exit the ENTIRE POSITION, if it shows you a net loss of more than X percent of your initial cash commitment. Bail out of both the long and the short, and go completely flat. Just guessing, I imagine that X may be in the range of 0.1% to 1.0% of your initial cash commitment. But that's why you run tests, to examine the data and refute the naive assumptions and opinions.

Thanks for the reply, Ted. You're one of the heavy hitters on this forum.

Exiting the entire position - I'll test it, but it doesn't really fit what I want to do. I didn't explain the system well enough, so it's my fault. However, you are the second really smart person to bring up pairs trading in response to this question. Hmm..

Here is a little more - The system is based on an indicator. We are going to run this indicator on entire portfolios of stocks, and choose the strong and weak performers. This will probably be the top and bottom deciles (or something like that) of the portfolio. We haven't decided if we are going to run this separately on sectors, or simply have widen the parameters and use it on the whole market portfolio. We'll test many variations, I am sure.

However, there will be many stocks in this portfolio, so exiting the whole pos would not be wise - even if we were using just sectors. However, I'll test that too.

I just bought smartquant, so after the learning curve, I will keep you posted.

Just as an aside, I asked this question on another forum. It seems like the answer to this question is a heavily guarded secret, and got several dismissive replys.

I've done a fair bit of actual research on equities but almost nothing on market neutral strategies. That's why I didn't respond earlier. I just don't have enough direct experience to answer like I would like to.

I do want to do some more research over the next year or so. Some of the ideas that I'd like to look into are:

1) Look at replacements of one side rather than exiting. If the expected weak stock overperforms or the expected strong stock underperformas past a certain threshold replace it with the current best candidate (weak or strong).

2) A similar idea is to examine the spread and if it goes too far out then refresh the entire pair with the current best pair.

3) Stop out sectors if an entire sector doesn't behave well (similar to 2 above but approached on a sector basis). I'm assuming you'll have two or three pairs per sector at minimum.

A little more detail on your funds goals would also help. What sorts of returns do you need? What types of risk levels are tolerable?

The answers to the questions you ask are very much the crown jewels of some of the better hedge funds. I found that the equities hedge funds are more sophisticated and more secretive than the managed futures funds. It doesn't suprise me that you'd find dismissive replies elsewhere.

A little research has revealed portfolio optimization is commonly used as a position sizing tool for this style of strategy. Portfolio optimization doesn't answer when to get out, and I think runs into several problems with use of correlation and relative risk size of positions. PO seems to me like running an options book where you hope your big positions don't blow up in your face and hope your little ones make you enough money to justify them.

The strategy is still in flux, but the basic source of 'alpha' is sound -it is just a matter of using it in a robust manner.

You might like to try my very special and highly exlusive recipie for success in long/short, beta-neutral stock trading.

When you have winning stocks on the long side, snatch up the profits as quickly as possible and allocate the funds to the biggest losers on the short side- then replace the long stocks by buying the cheapest stocks you can find. Likewise, when you have winning stocks on the short side, quickly take the profits and transfer the resources to the largest losers on the long side- then replace the shorts by selling short some stocks that are making new highs.

If you keep doubling down with this methodology, you are eventually bound to win. This metod is a gaurenteed winner- there is no need for any testing.

Shakyamuni is either being sarcastic or he's about to lose a lot of money I'm betting on the sarcasm. I can almost hear the feigned innocence in his "Why, whatever do you mean leonardo?".

Actually, I think you can do Martingale as long as you have a cutoff. Doubling each time might be too much, but adding to your position as the market goes against you a few times can work for certain types of systems, i.e. counter-trend or mean-reversion systems.

My testing indicates the need to have a point where you stop doing this, assume that the conditions supporting the trade are no longer present, and exit your positions; otherwise you might end up with a Long-Term Capital Management problem.

The German geniuses who run Wealth-Lab, are quite enamored of Martingale betsizing. No sarcasm. The very top ranked free systems on their website, are pure Martingale: Buy low. If it goes lower, buy more. If it goes still lower, buy still more. Really.

These are stock systems and for consistency's sake, the Wealth-Lab website automatically tests them (every day!) on the 100 stocks of the Nasdaq-100 index. Here's a table lifted off their website today. The column "APR" means Annual Percentage Return, i.e., Compound Annual Growth Rate. WL Score is a proprietary figure of merit that prizes high CAGR, low drawdowns, and low exposure (time in the market).

Now it must be stated, that some of these systems take advantage of a feature* of the Wealth-Lab test engine: For day-trades (enter and exit on same day), unlimited margin is permitted. That is, you can buy $100K worth of stock in a $5K account, as long as you close out your position the same day you open it.

Forum Mgmnt wrote:Actually, Martingale will always win when you have unlimited margin and infinite liquidity.

Yes but win how much? As the losing streak gets longer, more and more money is chasing less and less profit. But if you have infinite money then presumably the rate of return is not really a bother, eh?